The last opportunity for effective action before disaster strikes

Summary: The Paulson Plan is already irrelevant. New and larger measures are needed immediately. This is the second post in a series describing their size and scope. We are only weeks away from disaster. Fortunately, I am certain that Secretary Paulson and Chairman Bernanke know this. Bernanke, as an expert on the Great Depression, certainly understands the need for fast and effective action.

Situation report

The end of the post-WWII debt supercycle started with the collapse of the mortgage brokers in December 2006. Since then the government has made aprox 15 initiatives to stop the deterioration of our financial system. The super SIV, 3.25% in cuts to the federal funds rate, FHA Secure, Hope Now, a $120 billion tax rebate, massive expansion of access to the Fed’s discount “window”, TAF auction, TSLF, PDCF, the Bear Stearns bailout, the nationalization of the GSE’s and AIG … and now the TARP (aka the Paulson Plan). Don’t bother looking up the acronyms, they will all soon be forgotten.

All too small, too late. Incremental and reactive, responding to critical problems of last month — irrelevant to the current situation. This is a recipe for disaster. Like in the US 1929-1933 and Japan 1989-1996 — delaying the necessary large-scale response until the problem was no longer manageable.

Now the US financial system is seizing up. The machinery remains, but the gears no longer turn. Most of you have no idea to what I am referring, but you will learn over the next few weeks. To use a bad medical analogy, the financial system has had a cardiac arrest. Rather than describe the problem, this post describes solutions.

Restarting the necessary flows through the business credit system must be done immediately, and will require drastic measures. The following indicate the broad scope and scale of the necessary action, not the specifics.

(A) Broad guarantees of the securities for the financial sector. Not just banks and brokers, but also leasing companies and lenders of every flavor. Confidence in these securities must be restored now.

The Paulson Plan is only a small first step in this direction. More is needed, fast. The Fed is pumping vast sums into the financial system (“Wall Street”), but the money is not reaching “Main Street.” Disintermediation is necessary.

(B) Direct lending to business. For example,

(1) Direct loans to corporations by the Fed (e.g., Fed purchases of commercial paper from companies). Update: the Fed has begun doing this, per this announcement.

(2) Fast loans from the Small Business Administration on simple security (personal guarantees and net assets of the business). As were made to families after Katrina.

The full effects of the recession will hit in the next few quarters, and the current financial crisis has exacerbated it. We should prepare for something longer and deeper than 1973-75 or 1980-82 (the worst since the 1930’s). Let’s not wait to begin mitigation efforts. Anyone asking “Dude, where’s my recession” should be banned from the Internet for life.

(C) Massive fiscal stimulus. Government spending on valuable infrastructure. Expanded education programs. Fast cash disbursements to local social service agencies. Avoid the usual chaotic rush — begin setting them up now, as their lead times are long. The alternative is dropping money from helicopters later. This is essential, but logically part of recommendation #2: stabilize the economy.

Details

This is triage. Immediate aid to those who can survive. Fairness and equity are now irrelevant luxuries. Punishment of the innocent and rewards to the guilty can wait until the immediate crisis has passed.

This is just first aid. The recession is coming. None of these measure will speed its end or lay a foundation for an economic expansion afterwards. Such measures must wait for the new Administration. The timing of the crisis, in the midst of a critical national election, could not be worse. Let’s hope our leaders can put aside their partisan differences to take the necessary steps. Let’s promise electoral death to those who cannot manage to do so.

I doubt we can take these measures without prior agreement of our creditors. The additional — and larger — measures necessary next year will certainly require their money, so let’s consult them now — rather than arouse anger by assuming their cooperation. For years they have provided vendor financing — loaning us the money to buy their goods. Now we ask them for much larger loans to mitigate the results of our past imprudence. Without their aid we cannot simultaneously obtain the necessary funds, keep interest rates low, and avoid a collapse of the US dollar.

This is one of the major inflection points of American history. The outcome will be shaped to a large degree by the skill and values of the new Administration. Please do all you can to help America make that decision. Donate your time and money. Get involved in discussions. Write and talk about it with everybody you know.

What should we do next, after applying First Aid?

That is a complex question. For a simple answer see the following (you will not like the answers):

Krugman and Roubini are among America’s top economists; Buffett is one of our top businessmen. Their warnings deserve close attention. Esp note Buffett’s comments:

We have a terrific economy. It’s like a great athlete that’s had a cardiac arrest. And it’s flat on the floor, and paramedics have arrived. And they shouldn’t argue about whether they put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way. Or they shouldn’t start criticizing the patient because he didn’t have blood pressure tests or something like that.

They should do what’s needed right now and I think they will. I think the Congress will do the right thing. I think that they’ve gotten into certain arguments and then they start worry about assessing blame and there’s a little demagoguery. But in the end, something this important, they’ll do the right thing. This is really an economic Pearl Harbor. That sounds melodramatic, but I’ve never used that phrase before, and this really is one.

The crisis deepened after the worst month for corporate credit on record. Leveraged loan prices plunged to all-time lows, short-term debt markets seized up and even the safest company bonds suffered the worst losses in at least two decades as investors flocked to Treasuries. Credit markets have frozen and money-market rates keep rising even after central banks pumped an unprecedented $1 trillion into the financial system.

“The credit window is closed,” Jim Press, president of Chrysler LLC, the third-largest U.S. automaker, said today at the Paris Motor Show. … “It’s going to get much, much worse,” said Gregory Peters, head of credit strategy at Morgan Stanley in New York. “The credit markets are effectively shut, the CP market, which there’s not enough focus on, is under complete duress. That can’t be sustained, as that’s the lifeblood of corporations funding themselves.”

Commercial banks and bond dealers borrowed $348.2 billion from the Fed as of yesterday, an increase of 60 percent from the prior week amid the worsening credit freeze.

The market for commercial paper plummeted $94.9 billion to $1.6 trillion for the week ended Oct. 1 as banks and insurers were unable to find buyers for the short-term debt amid the worst U.S. financial crisis since the Great Depression. Financial paper accounted for most of the decline, plunging $64.9 billion, or 8.7 percent, to a two-year low.

…”The purge is broad and is impacting issuers with far more predictable cash flows — regular run-of-the-mill companies in need of working capital,” Crescenzi wrote today in a note to clients. “The declines add to the urgency for fixes to the credit crisis and bolster the case for a Fed rate cut.”

The U.S. market for short-term debt backed by assets including mortgages and car loans fell $29.1 billion, or 3.9 percent, this week to a seasonally adjusted $724.7 billion, according to the Fed.

Afterword

If you are new to this site, please glance at the archives below. You may find answers to your questions in these, such as the causes of the present crisis. I have been writing about these events for several years; since November 2007 on this site. As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.

Please share your comments by posting below. Please make them brief (250 words max), civil, and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

This crisis has long been forecast by many, including in articles on this site. Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results. To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime. Here are some of those posts.

Let capitalism work. The MARKET will bankrupt the stupid, greedy, bast**ds as it should. Then the MARKET will brush itself off and continue to function. It’s just a momentary disruption. No big deal!
.
.Fabius Maximus replies: This is a familar recommendation. Robert Taft, and Andrew Mellon will have their modern equivalents, advocating the hard path that leads to long-term prosperity. President Hoover wrote in his Memoirs that Mellon, as Secretary of the Treasury, had

… only one formula: liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate…. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.

Yep, current events are “no big deal.” Just like the 1929 – 1932 crash was “no big deal.” Unfortunately by the time the people with such views are proved wrong, the damage will be severe. Don’t look for them to admit their mistakes or apologize.

Japan and China maybe the only ones who are in a position to help and do they have enough to help out the west in general. For China this is a rare opportunity to defeat not just the US but the west without fireing a shot. We are in a very precarious position. This is where greed, leverage, debt, dependence, and partisanship has brought us. Everyone who is an incumbent from city and counties all the way up are guilty of gross negligence but will they be fired at the next election? No! It may be time for a third party put that won’t happen for 2 more years.

Despair is a sin. Hopefully someone is listening.
.
.Fabius Maximus replies: Add the Gulf states, esp the Saudi Princes, to the list.

The Telegraph op-ed is a fun read. Underlying this is a more serious issue: can the European Monetary System survive a recession? Milton Freidman said “no.” Papers have been written on both sides of the debate. Here is the latest, a typical economists who nicely describes the problem and concludes “perhaps yes, perhaps no.”

“The various credit crises we face are real, notwithstanding the facetiousness with which I began this column. Anyone who doubts this should look into shipping news. All over the world, ships carrying vital commodities are failing to load and sail because banks are currently too shy to extend modest, conventional credit instruments. The cumulative effect of that, and much else like that, will soon bring home the reality of failing banks even to those who keep their money in pillows.”

If nobody in the Administration, campaigns, or house/senate leadership will stand up and lay the root cause of this melt down where it belongs – at the feet of the congress, in the persons of Carter, Clinton, Frank, Dodd, and the curse of income redistribution, then there’s no sense in pursuing a government solution.

No good money after bad. If you won’t identify the problem, name the enemy, you aren’t serious about fixing it.

Let the market be a market. And I hope that we’ve got enough lamp posts in D.C. to do the pay proper respect to our outgoing legislators.
.
.Fabius Maximus replies: Ah, the old song. Robert Taft, and Andrew Mellon will have their modern equivalents, advocating the hard path that leads to long-term prosperity. President Hoover wrote in his Memoirs that Mellon, as Secretary of the Treasury, had

… only one formula: liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate…. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.

Current events are “no big deal”, just as 1929-1932 was. By the time these folks are proven wrong the damage will be beyond anything they imagine possible. If history is a reliable guide, we should expect no apologies.

Since the ‘bailouts’ are all about protecting the 535 jobs in the Capitol building, I’m already disinclined to believe the ‘sky is falling.’ The credit crisis right now is as much as banks *expecting* the hand out and ceasing business because they expect to get inflated value for their merchandise.

This whole thing is cause by a lack of market freedom. Restricting it further will just create a larger problem down the road.
.
.Fabius Maximus replies: There is no need to rely on Washington or Wall Street to see the seriousness of our situation. Main Street is already feeling the effect, as normal channels of credit have dried up. Another week and the effects will be immense. Another month and they will be beyond your worst nightmares.

As for the reliance on market freedom, I suggest you read the history of 1929-1932.

“I doubt we can take these measures without prior agreement of our creditors. The additional — and larger — measures necessary next year will certainly require their money, so let’s consult them now — rather than arouse anger by assuming their cooperation.”

And if we fail to secure their cooperation? Europe is now facing a bank solvency crisis of its own. Our Asian and Arab creditors may decide that Europe is the better credit risk. They may even decide that slowing growth and rising inflation at home deserve more attention than U.S. insolvency.
.
.Fabius Maximus replies: And your point is? We can only try. I doubt that they will allow their largest customer and the core of the world’s financial system to crash. They will, however, ask for concessions in return.

Looking over some of those links I’m impressed how biased or out-dated they are. Anthony is quite right that European banks and insurers are in worse shape than American institutions. And China’s must be an absolute disaster of jury-rigged plans.

If our choices truly are an either-or between surrendering the last bastion of liberty to the evil of socialism and letting the world economy collapse, I say let it burn. Then we pick ourselves off and carry on like we have before.
.
.Fabius Maximus replies: I suggest that you do not so quickly draw conclusions.

* Europe has been affected, but it is not clear how badly. To say their “banks and insurers are in worse shape than America’s” is not supported by the available data.

* To say “China’s must be an absolute disaster of jury-rigged plans.” is just a wild guess. Many western observers (e.g., Stratfor) have been predicting China’s collapse since Dinosauers walked the Earth. (OK, not quite that long – but it seems like it).

“I say let it burn. Then we pick ourselves off and carry on like we have before.”

That is one of the more irresponsible statements I have heard in a long time. I suggest reading some history to learn of the consequences of such events. Not just in the human suffering they cause, but the often terrible changes they make in societies. I suggest starting with these:

“Before the Deluge – A portrait of Berlin in the 1920’s”, by Otto Friedrich
“The World of Yesterday”, Stefan Zweig

Dude, recessions are when you get dragged back to reality. You’re $9.7T overspent in the US and a similar amount in France, Germany and the UK. Those credit card companies are calling you, Fabius. You need to pick up the phone and let them know when you’re going to pay them the money you owe. Credit is siezing up? I should say so. That’s what happens when you spend, spend, spend.
.
.Fabius Maximus replies: How nice that you have such a fun attitude to this crisis. I assume you have some basis for confidence that it will not spin out of control into something causing immense suffering. Like 1973-75 or 1980-82. Or worse (which I consider likely).

On another level, I find your indifference to the suffering of your fellow Americans quite astonishing. I assume you would act differently if your neighbor’s house was burning, or you found someone injured in the Street. To say “its the circle of life” sounds good in a Disney movie (esp when set to song), but that is meant for children.

While they’re at it, I hope they hasten the demise of the large banks by encouraging direct internet match making between lender and borrower. There is no longer as much need for the historical banking function of qualifying worthiness of borrowers. Private investors are already supplying liquidity through direct lending. This is a continuation and logical extension of other developments which have already badly damaged conventional banks. Why do you suppose banks have been breaking their usual lending rules? Partly pressure from Barney Frank, but also a variation of “Desperate men do desperate things”. Our credit system is ossifying because the cream of the business is going to internet “bankers”, while the boring dross remains in the old banking entities.
.
.Fabius Maximus replies: Do you have any evidence for this?

I’d worry about the government. Why do you think so many revolutions come at the end of supposed eras of prosperity? Because of the greed and disgust with the political elite.

President Bush, Congress have zero clout with the American people. The only thing they have is to promise anyone, anything, at any price. For now.
.
.Fabius Maximus replies: Do many revolutions come “at the end of supposed eras of prosperity?” The American revolution did, but that was exceptional in many ways. The French revolution resulted from the bankruptcy of the monarchy. The Russian revolution resulted from defeat in WWI.

I agree with Paul from Florida, but not to the point of revolution. The whole bailout bill screams of desperation – a desperation to avoid the reality that 40 years of Keynesian economics has led us to a culture where paying for what you buy is for the chumps.

I’ll say it again. Fabius, we all owe $9.7 TRILLION dollars. This spasm of spending $700B or $900B or $1.1T or whatever isn’t going to hide the fact that we’ve borrowed our way into a massive financial hole. As anyone who’s hear Dave Ramsey knows, spending still more isn’t going to get you out.
.
.Fabius Maximus replies: The US government owes $5.8 trillion dollars in net debt (the result of past expenditures). The other $4.2 trillion is debt the government owes to itself (part of the gross debt). Write yourself an IOU for a million dollars. Has anything changed?

Either way, this is on the low end of the range as government debt goes, and not a problem for a $14 trillion dollar economy.

“Considering this projected gap in social insurance, in addition to reported liabilities (e.g., debt held by the public and federal employee and veterans benefits payable) and other implicit commitments and contingencies that the federal government has pledged to support, the federal government’s fiscal exposures totaled approximately $53 trillion as of September 30, 2007, up more than $2 trillion from September 30, 2006, and an increase of more than $32 trillion from about $20 trillion as of September 30, 2000.7 This translates into a current burden of about $175,000 per American or approximately $455,000 per American household.”

“your indifference to the suffering of your fellow Americans quite astonishing. I assume you would act differently if your neighbor’s house was burning, or you found someone injured in the Street. To say “its the circle of life” sounds good in a Disney movie (esp when set to song), but that is meant for children.”

How old are you Fabius? I spent the last three years getting out of a deep financial hole. Indifference? Hardly. I walked through Costco the other day and could recall a time just a little while ago when I couldn’t afford a broom. A freaking broom was too much for my budget.

I got myself out of debt and I’m doing fine because I sucked it up and paid off my loans. A cruel person would have advised me to keep borrowing. I’m not the one who is indifferent to suffering, my friend. We owe something like $27,700 each on the debt. That’s $110,800 for a family of four. Pay up.
.
.Fabius Maximus replies: Probably older than you, but that is irrelevant. I was not referring to your awareness of your personal suffering, but your sensitivity to that of others.

The core of modern economics is that recessions and depression are good neither for our soul nor for the economy. They usually result from policy errors. Just like most traffic accidents. Failing to take corrective action to avoid a recession is as morally just as failing to steer around the tree when driving a busload of kids.

Well, the investment banks used to make a pretty penny trading bonds by exclusively knowing the real time spreads in the bond market through their front row seat status. Bloomburg ruined that franchise and became a billionaire in the process. Today, everyone knows the spreads in real time due to Bloomburg. I’ll send you a link for a gal in Oakland Ca. who does direct internet matchmaking for home mortgages. She’s doing very well.
.
.Fabius Maximus replies: Bond trading is a tiny tiny dot in the overall financial sector — and not relevant to what you described in your previous comment.

“As for the reliance on market freedom, I suggest you read the history of 1929-1932.”

Fabius, what a load. Hoover was “The Great Engineer” and he too tried to inflate the money supply after a long boom and it didn’t work. He also had in place all sorts of public works projects to jump start the economy. There was noe “market freedom” back then. Just like there hasn’t been market freedom for the past twenty years. It’s been all about government interventing. In this case a price ceiling on interest rates, and GSEs.

The bailout will not avert the correction. It will only posepone it.
.
.Fabius Maximus replies: OK, I do not understand what you are attempting to say.

(1) If you are defining market freedom as a theoretical condition never tried on Earth, perhaps you are correct. I don’t see the point of mentioning it, unless you are telling us about the wonders of Heaven. Down here we try to avoid recessions and depressions, or at least mitigate their effects. If you disagree, that’s fine — but I doubt you will get many people to agree with you. Certainly nobody familar with history.

(2) As I have explained at some length — see the links in my post — the bailout (I assume you mean the Paulson Plan, now in Congress) is irrelevant to our current problems. It will not postpone anything.

The general price pressure comes from a “race to the bottom” effect, induced by Rockefeller’s “Ruinous competition”, internet style. Banks used to extract profit from borrowers inability to determine the current fair market price of loans, but today borrowers have pretty much Zen like awareness of what constitutes a fair deal. How can I prove this? I can’t, but it seems pretty likely that banks have been sustaining profitability by assuming ever more risk. The ever more risk part is becoming evident. Bank profitability as a reward for taking this risk on has not soared for any banks I know of. You would expect higher volatility in bank profits combined with higher mean profits industry wide given the added risk they took, but I don’t think that has happened even looking back. I guess I’ll cop out and say that higher risk without higher reward is the market response to banks losing their old status as low risk moderate profit endeavors.
.
.Fabius Maximus replies: You have describe part of the reason for declining bank margins. Some others are…

* Disintermediation (corporations can directly tap security markets for money).
* Collapse of profit margins on many products due to technology.
* Increased competition due to growth in number of financial instutions.

As a result financial institutions sought to maintain profits by measure such as…

* Increased leverage on their balance sheet.
* Provide credit to more-risky customers, both business and households.
* New products (derrivatives, such as interest-rate and credit-default swaps)

Better regulation could have kept these trends under control. But “regulatory capture” is a dynamic identified in the early 1970’s, as regulators repond to the needs of their “clients” more strongly than their assigned mission. In any case, that is all water over the dam. The financial system will be unrecognizably different when all this is over, so no point in pointing fingers — or discussing how to stop horses that have long since left the barn.

Since the government is, as always, the problem, I find myself saddened but unsurprised by the readiness of individuals who should know better to turn to the government for a supposed solution. It matters little how bad the current crises is – and I tend to agree with you that the looming market correction will be a bad one – no bill that our congress passes, bailout or otherwise, is going to be more than a temporary stop gap that will do nothing except postpone the fall (and make it, ultimately, worse).

Further, since any such bill will also (as all such previous instances in our history have done) lead to the aggregation of yet more power unto Washington and the further erosion of our freedoms, I find that the only sentiment I can bring myself to is to hope that these incompetents we’ve chosen to represent us doing nothing at all.

I’ve seen you repeat, many times, that those advocates of letting the market do its job should read up on history circa 1929-1933. I would riposte that you would be wise to look at history circa 1933-1941, wherein government interventionism in the guise of recovery served only to prolong the pain.
.
.Fabius Maximus replies: As I have explained at length — and mentioned in this post and others — the Paulson Plan will probably do little. Which is why larger measures are necessary, or the system damage will spread through the economy. The belief expressed in so many of these comments, that the “free market” fairy will save us, has no support that I am aware of in history or theory.

As I have also shown, any measures we are likely to take will concentrate power — both in the government and (more broadly) among our governing elites. On the other hand, the consequences of doing nothing could be very bad. It is evident that many of the folks commenting here have no idea what that means.

As for the 1930’s… It is clear that the policies of the US and UK made the depression needlessly long and deep. Only WWII blasted us into recovery, after 1938. Of course, Lord Keynes published “The General Theory of Employment, Interest and Money” in 1936, so our mistakes were not clear at that time. But how can you support this:

“wherein government interventionism in the guise of recovery served only to prolong the pain”

The nations that did well in the depression — esp the Scandinavians and Germany — had more intervention in the economy than us, not less.

Since banks and other institutions were coerced by government to make loans that would never be paid off and then were ENCOURAGED to create vehicles and practices to morph the trash into assets and THEN were successful in seeing government become the last player in the musical chairs, where should the pain rightfully be felt?

There’s not enough numbers in both houses of Congress to make more than a splatter on the pavement. But we are still truly, if woefully ineptly, a government of, by, and (ha)FOR the people.

So, the responsible parties are about to pay. That’s us. You , me, the neighbor.

I take no comfort in the knowledge that if our economy is this screwed up, the nannystates across the water must be three times’ worse off than us. The debt that we shouldered as world policemen was never felt by the old countries; they started buying their balloons and cake decades before we started seriously slouching toward serfdom.

It’s going to be bloody. But if you stick your hand in a wood chipper, can you really be surprised? Didn’t think so.

Don’t worry! O! is going to save the day! Ha. That right there is going to be good for a thousand points down on the Dow on Monday, isn’t it? I wouldn’t want to be Barney Frank this time next week.

Oh, and don’t try that “better” regulation schtick. If you can’t start with “ethical”, “better” isn’t even a possibility.
.
.Fabius Maximus replies: The myth that the Community Reinvestment Act (passed in 1977) had any significant role in the US debt supercycle was thoroughly debunked in this thread. A dozen studies were cited in rebuttal; the proponents cited nothing but assertions in support of it.

“As I have also shown, any measures we are likely to take will concentrate power — both in the government and (more broadly) among our governing elites. On the other hand, the consequences of doing nothing could be very bad. It is evident that many of the folks commenting here have no idea what that means.”

The whole problem with the idea that “the consequences of doing nothing will be bad” is that it presupposes that there is some course of action that yields an outcome that could be characterized as “not bad.” No such course of action exists. The current US economy is unsustainable; it will correct itself, one way or another. You are likely correct that an ideal course of action will mitigate the pain to some extent – my quibble is not so much the course of action you propose as it is the actors chosen for implementation.

It is all well and good to assume fiat – to claim that “this needs to be done, or that.” However, the second you bring this argument before our body politic and present it as a course of action, that assumption falls flat. I will claim categorically (and I have seen zero evidence in our recent history to challenge this assumption) that /no/ measure likely to pass this congress will be to the benefit of our nation.

“The nations that did well in the depression — esp the Scandinavians and Germany — had more intervention in the economy than us, not less.”

I am not sufficiently familiar with the economic history of the Scandinavian nations to provide comment, but I will say that I am highly surprised you chose Germany as an example. First off, the Weimar Republic was hit especially hard by the crash, and thus an equivalent climb from its minimum appears proportionally much greater. Secondly, Germany rose out of the depression by completely throwing of the shackles of said republic, favoring a Fascist tyranny instead – and, if there is one thing that dictators have proven themselves good at, it’s making the trains run on time. The short term result was favorable – the first bloom of tyranny – but the end result can hardly be called an improvement. By 1940, the German economy was falling down around Hitler’s ears.

Lastly, regarding my comment that “government interventionism prolonged the pain,” I would consider this to be self-evident. It’s commonly accepted that the New Deal prolonged the recovery, and we are even now feeling the after-effects of its policy. In fact, as a direct result of the New Deal, we are facing a near-term crisis in the form of the coming Social Security insolvency issue that will make even our current financial woes look small.
.
.Fabius Maximus replies: That’s a pretty exteme position, too extreme to debate in this small forum.

Much of this seems to rest on counterfactuals — such as “how the US would have done without the New Deal.” Or “what would a modern economy look like with minimal regulation.” These are outside my pay grade to discuss. All I can say is that you will find few experts in economics or finance who agree with you.

“the Weimar Republic was hit especially hard by the crash, and thus an equivalent climb from its minimum appears proportionally much greater.”

What crash? This is not correct, to the best of my knowledge, as Weimar was not hit hard (certainly not more than the US) by the 1929 stock market crash.

“Germany rose out of the depression by completely throwing of the shackles of said republic, favoring a Fascist tyranny instead”

German’s economic performance in the 1930’s was largely a function of what we would now call Keynesian fiscal stimulus. Massive government spending, far more than FDR’s. It worked, as easily seen by comparing pictures of German and British enlisted men in WWII. The Brits tended to be smaller than the Germans, and bowlegged. Poor diet in childhood, mostly. Now if only Hitler had ambitions other than war…

“if there is one thing that dictators have proven themselves good at, it’s making the trains run on time.”

This is a myth, originally said of Mussolini. See Snopes (or any biography of Italy in that era) for a debunking.

the fed needs to stop conducting auctions for term funds. they need to set the rate and supply whatever is needed. they need to target not only the overnight rate (pay interest on reserves instead of the current add/drain to hit the funds target), but target 1 month to 3 month rates.

we should not worry about a fiscal deficit of 10% of gdp as the federal government will be the only entity able to affect agregate demand until private sector balance sheets are restored.
.
.Fabius Maximus replies: I am not an expert in money market operations, so I assume the Fed’s procedures in these things are the best ways to conduct this monetary policy (they are good at this stuff).

The question is not if we — the debtor — worry about a 10% fiscal deficit. Debtors never worry about such things.

The US will probably not have a sufficient savings rate to fund such a large fiscal deficit. We are almost totally reliant on foreign central bank lending, which they have done to finance our purchases of their goods. But this borrowing will be different, for internal consumption not trade finance. Will they share your complacency about funding a large piece of $2 trillion dollars in 2009 borrowing (10% of $14,000 b plus $500 b in maturing debt)?

“The core of modern economics is that recessions and depression are good neither for our soul nor for the economy. They usually result from policy errors. Just like most traffic accidents. Failing to take corrective action to avoid a recession is as morally just as failing to steer around the tree when driving a busload of kids.”

Poppycock. Modern economics is built around an entitlement mentality that says we can have endless expansions and our government can drive the economy to accomplish this. Both are false and both have made this situation worse than it had to be.

If you are spending more than you earn, you are building up debt. You will need to first reduce consumption to the point where income = expenses and then reduce consumption further to the point where you can pay down debt. That’s a recession. It’s an involuntary reduction in consumption to make up for past excesses. We have massive government debt and now, massive, unpayable mortgage debts. That’s a pretty good mix of past excesses.

As for the government driving the economy, Barney Frank can’t even run a gay brothel in his home without screwing it up. Now we’re ask him to help “run” the banking system through the control systems of the government. Good luck with that.

It’s not that the market is superior, it’s that it has an inexorable mathematical quality to it. It cannot be denied. Lots of people took out loans they couldn’t pay back. The loans still have to be paid. The government gives us all $400B more worth of treats and toys than we pay for. Those have to be paid for. The money has been borrowed so we could all pretend we were rich when we weren’t. It has to be paid back.

You may be right that the bailout is necessary to stave off a worldwide depression. If we stave it off and keep living beyond our means, we are still screwed in the end.
.
.Fabius Maximus replies: Lots of extreme views in the comments on this post. Interesting that nobody so far seems able to cite actual evidence, in theory or history, for their views.

“Modern economics is built around an entitlement mentality that says we can have endless expansions and our government can drive the economy to accomplish this.”

Can you support this statement in any way? I am aware of no school that believes that the business cycle can be prevented. Of the three major schools of economics, two discuss how to manage the cycle (Monetarism and Keynesian) and the third says we must mnage mostly the upcycles (Austrians). These are caricatures, of course.

“What crash? This is not correct, to the best of my knowledge, as Weimar was not hit hard (certainly not more than the US) by the 1929 stock market crash.”

Oh, the perils of hyperbole. I didn’t mean the stock market crash in specific; I meant, rather, the ultimate economic minimum before the recovery began.

I’ll leave the rest as a simple “agree to disagree,” with one additional comment: I am by no means an expert in economics (although, to the extent I have studied it, my preferred flavor is Austrian), but I know enough history to know that, however bad our economic problems may be, the long term issues created by our efforts to solve it will be worse. There is simply no way around the law of unintended consequences, and any long term aggregation of government power in exchange for short term benefit is no bargain at all.
.
.Fabius Maximus replies: I don’t believe your characterization of Weimer’s experience in the great depression is correct on any level, not even as hyperbole. Their hyperinflation during 1921-23 removed many of the economic imbalances, such as high debt levels, that made our depression so severe. So they had a less severe crash.

As for the rest, it is an extreme position but beyond the scope of discussion on this site.

That a company like GE feels the need to issue new shares in the present market conditions shows the tightness of liquidity in the banking sector. GE having trouble borrowing money!! Scary. I wonder when you will begin to see solvent companies defaulting on debt & wages etc., etc., because they are hit with a lack of liquidity….

Are there any US banks with surplus liquidity anymore?
.
.Fabius Maximus replies: Lots. They are just not lending. The Fed is pouring liquidity into the financial system, but little of that is reaching the business sector.

I find it hard to believe that “credit has frozen”. Banks are in the business of lending money, if they don’t lend then they have no reason to exist. What I think more likely is that “credit has frozen at the current prices (rates)”. If you want to restart the credit markets then the institutions with money (asian, middle east) must be promised a payoff (rate) that matches perceived risk. However a rise in rates would crush those who are already in heavy debt OR whose balance sheets are so nontransparent that they are considered very risky borrowers.
If the number of indebted corporations/individuals is high enough (not just in absolute numbers but also in relative significance/influence) then it may be politically impossible to allow their failure. Other than bankruptcy the only way to get rid of existing too-large-to-pay-off debt is to inflate it away.
So it is a choice: whether to prop up indebted USA corporations/individuals or to preserve the dollars’ status as global reserve currency.

“Modern economics is built around an entitlement mentality that says we can have endless expansions and our government can drive the economy to accomplish this.”

Can you support this statement in any way? Well here’s you supporting it.

“Failing to take corrective action to avoid a recession is as morally just as failing to steer around the tree when driving a busload of kids.”

You are presuming it can be known what the correct direction and magnitude of corrective action should be. You have no evidence for that.

You have also merely asserted and not shown that the just price of unintelligent sustained excess is not pain. I assert that it is, and point you to the Gods of the Copybook Headings. If the only way the pain which is coming can be shared to those who most individually contributed to it is to not bail out Wall Street, then that is an excellent idea.

BTW, in saying “recession is coming”, you admit those asking “Dude, Where’s my recession?” were perfectly correct when they were saying it.

And yes, the CRA and two other things are at the root of this crisis, the other two being the implicit federal backing of FM-FM and the willingness of the mortgage underwriters to make temporary profits by writing loans which the CRA* but not history justified.

*I do not assert the CRA demanded such loans in any but a few cases, but the fact any such loans existed meant many hundreds of thousands of loans which were not blatant quota loans were made which were not justifed by traditional criteria. Borrowers were saying, “If they–bad risk minorities–can get a loan, why can’t I?” and lender’s were saying, “If they have to get a loan–bad risk minorities–and it’s federally backed, why shouldn’t I loan to this better risk?”

Also, you keep on saying we should read up on the Great Depression, which started in 1929. I think you should read up on the The Law, which came out in 1850.

I disagree. The quote you open with (from comment #14) is an expression of my belief– a statement of applied morality; there was nothing in that comment about economics. Modern economics theory since Keynes provides a theoretical basis for acting on this, which of course you can agree of disagree with. None of this is relevant to the question I asked, asking for some evidence to support your statement that “Modern economics is built around an entitlement mentality.”

“recession is coming”,

Thanks for catching that sloppy writing. As has been evident in these posts, the recession started in Q1 (since we do not have accurate monthly data; if we did it would probably be Dec 2007). I meant the full and severe effects of the recession are coming; we have seen only mild early phases. (I have edited that to make this clearer)

“the CRA and two other things are at the root of this crisis, the other two being the implicit federal backing of FM-FM”

I agree with the latter, although “at the root” may be too strong. The myth that the Community Reinvestment Act (passed in 1977) had any significant role in the US debt supercycle was thoroughly debunked in this thread. A dozen studies were cited in rebuttal; the proponents cited nothing but assertions in support of it. Also, what are you quoting from (no source is given for that paragraph near the end)?

Yes we must do something – call your representative and tell him to vote against the bailout. Doesn’t anyone see what’s happening here?
Monday – bailout vote and market tanks.
Tuesday – previous day bailout vote fails – market starts to recover. DJIA came close to having the largest one day rally ever.
Wednesday – market nervous about bailout vote – down slightly.
Thursday – previous day bailout vote passes – market tanks – Reid scares insurance co. investors.
Friday – bailout vote – market nervous – will be close to even – might be up slightly on insurance co investers.
Monday – if bailout passes and Bush signs, the market will have the largest down day ever – losing 2K points.

Problems in the market? “It’s the bailout, stupid.”

Paulson is an ex Wall-Street CEO, with a 3/4 billion dollar trust fund that’s sinking fast. Of COURSE it’s a crisis and a bailout needs to be passed – or he’ll lose nearly 1/2 billion dollars. Oh, sorry George, were you thinking I meant it was a crisis for the country? My bad…

Reminder: It’s easy to exaggerate a crisis in moments of crisis. It happens all the time.

About the €: The fundamental problems of the Euro are the large differences between the participating countries and the lack of exchange rate balancing of asymmetries. I don’t see how the Euro zone could be split by a crisis that affects all.
.
.Fabius Maximus replies: Yes, but that is not happening now, on the basis of clear and objective data.

Unfortunatly, I think Fabius is right, and its probably exacerbated by something I just realized: There is so much reliance on very short term financing.

So many companies, and all banks, get a huge fraction of their liquidity on the commercial paper, overnight loans, and similar markets. As witnessed by the TED spread, still continued withdraws from money-market funds dispite the treasury backstop [1], complaints from AT&T, McDonalds, etc.

This means that things, without an explicit government backstop, things can unwind VERY quickly when companies can’t roll over their loans. So a company can go from “fine” to “no cash at all” in a month or even overnight.

My GF just got fired from a little company, that, I bet, will not be able to make payroll in a month: They have some very nice assets (which are probably already collateral against loans) but no liquidity. With no liquidity, you can’t make payroll. You can’t make payroll, you cease to exist as a company.

Lord only knows how many companies don’t have the liquidity to survive a real credit crunch.

This IS bad. Very bad.

[1] There are two problems: The backstop is ONLY against existing money, and as short term rates go to 0, there is so little margin for error. Its one thing to try to beat an index, its another to try to beat 0 when treasuries are yielding 0%.

Despair is the absence of hope. As Christians, we are to have faith in the Lord, hope in our salvation, and to be content in our daily life.

I believe the scriptural basis for despair being a sin is Matthew 6:25-34.

“Therefore I tell you , do not worry about your life, what you will eat or drink; or about your body, what you will wear. Is not life more important than food, and the body more important than clothes? Look at the birds of the air; they do not sow or reap or store away in barns, and yet your heavenly Father feeds them. Are you not much more valuable than they? Why of you by worrying can add a single hour to his life?”

See also Philippians 4:12-13.

I know what it is to be in need, and I know what it is to have plenty. I have learned the secret to being content in any and every situation, whether well fed or hungry, whether living in plenty or want. I can do everything through him who gives me strength.
.
.Fabius Maximus replies: Thanks for this info!

Companies that “depend” on short-term loans for paying salaries can in a very short time change their liquidity management to keep some M3 money – the additional cost is marginal, a little bit of interest rate, that’s all. Banks don’t give away money as before, but they receive more than before from the Fed – now guess what – there’s a lot of money in the system, just not where it used to be. There’s even more money than before.

A reduction in loans is actually a good thing – about USD 700 billion consumption less would delete the trade balance deficit. The USA has lived beyond its means as a nation 8trade balance deficit), as a state (budget deficit) and even many as individuals (mortgage and credit card debt). THIS NEEDS TO STOP. A full stop of this insanity is nothing that needs to be averted, but something that should have happened years ago.

The U.S.Americans lived beyond their means and enjoyed it, were often arrogant to others based on illusions of (borrowed) power and wealth. Now is the time for payback, and the change will be brutal, but IT WILL BE A CHANGE BACK TO WHAT’S DESERVED.

Forget about trying to keep the consumption levels – both state and private – of the past years. It was not deserved, but loaned. Chinese and other foreigners were basically working for promises only – now it’s time to keep the promises and pay them.

The present financial markets crisis is only a symptom, something that could not have happened without the mentality that allowed the mismatch of consumption and income. (And don’t forget that the U.S. economy will not improve without huge investments, too).
.
.Fabius Maximus replies: This is like an emergency room team receiving a patient in cardiac arrest, and recommending a better diet and exercise. In a situation like today’s the causes are irrelevant. Those consideration will be important later, but not now.

“Companies that “depend” on short-term loans for paying salaries can in a very short time change their liquidity management to keep some M3 money”

Not possible for any reasonable time horizon. Companies that have short or long term debt maturing this month are in big trouble, unless they existing lines of credit sufficient to provide the cash. Few businesses have sufficient cash flow to payoff debt in any short to medium time; that is why they borrow.

I guess in your eyes, I’m just an uneducated American, but perhaps you could explain to me and the rest of us unwashed masses why business credit line rates haven’t changed and banks have not begun paying higher interest rates?

Again, I’m just a simpleton, but I would think that a bank staring a OMGWTFCREDITCRISIS in the face would begin adjusting these before throwing in the towel and calling for a taxpayer funded bailout…
.
.Fabius Maximus replies: There is no reason to say such things. Economics is not the highest nor more important branch on the tree of knowledge.

When people worry about a systemic crisis — normally credit-worthy customers paying them back — they just don’t loan. If you worried that I might not pay you back, what rate of interest would you charge? Nothing that a bank could offer without getting into big legal and PR trouble.

Oh, and by the way, not to point out that the Maximus has no idea what he’s talking about, but the U.S. Small Business Administration does not give direct loans to businesses. Never has (other than in disasters).

And the SBA lenders are still giving loans at the same rates as before the OMGWTFCREDITCRUNCH. Because they’re still Federally-guaranteed, and the banks have the same risk. Heck, I wouldn’t be surprised if they didn’t push to bump up the guarantee levels in the bailout bill and start moving 7(a) lending into mainstream loans.

Not to pile on to a over-educated gentleman who has no idea what he’s talking about.

Seriously, as a taxpayer, I’m getting tired of the BS predictions from investment bankers and brokers claiming the sky is falling. Maybe in Manhattan, pal, but for the rest of us, it’s just a regular old recession, and we’re not going to make it worse by handing you geniuses what hard-earned money we have left, courtesy of Mr. Paulson.
.
.Fabius Maximus replies: I suggest not making such snide remarks without actually reading the post.

“Small Business Administration does not give direct loans to businesses. Never has (other than in disasters).”

The title and text describes this as a disaster. And I specifically said “As were made to families after Katrina.” These recommendation are things that have never been done before (Fed loaning money to non-financial corporations, SBA loans directly to businesses), but are needed now.

“Maybe in Manhattan, pal, but for the rest of us, it’s just a regular old recession,”

This is a common reaction to extraordinary circumstances, like people on the beach hearing the tsunami warnings and dismissing them — “never happened, don’t bother running.” It sounds good, but often has unpleasant consequences. Like folks who believed the foolish “Dude, where’s my recession” articles — and failed to prepare for the current downturn.

The key is that the discussion and problem symptoms are about liquidity. Well, what happens when banks don’t loan money away? It certainly doesn’t lie all in their safes. No, the money is still in the economy, but business in the financial sector is not as usual, the money flows are changing. That’s why the bankers scream.

The banks did a terrible job in their primary task; efficient allocation of resources. They mis-allocated resources into building construction and snowball systems that were built around the housing market – and into consumption. Meanwhile, there was not enough money directed into real investments – or even only good real investments.

The financial system sucked at allocating resources and it sucks now, just for another reason – a reason that’s not pleasant, but painful for the financial branch.

The real economy problems happen not only because of some stupid problems in the banking sector – that’s just part of the trouble. No, the real economy is in trouble because of fundamental problems. It’s sick.
.
.Fabius Maximus replies: This displays a large-scale misunderstanding of how banks work.

When banks slow their rate of lending, they are reducing their leverage. Perhaps from 10:1 to 8:1. They do not work by taking a dollar out of their safe and lending it. They take it out and lend it 9-fold. So a reduction of lending is a reduction of “oxygen” to the economy.

Update: “Edge of the Abyss“, Paul Krugman, op-ed in the New York Times, 2 October 2008 — Excerpt:

“As recently as three weeks ago it was still possible to argue that the state of the U.S. economy, while clearly not good, wasn’t disastrous — that the financial system, while under stress, wasn’t in full meltdown and that Wall Street’s troubles weren’t having that much impact on Main Street.

“But that was then. The financial and economic news since the middle of last month has been really, really bad.

… “There’s growing evidence that the financial crunch is spreading to Main Street, with small businesses having trouble raising money and seeing their credit lines cut. And leading indicators for both employment and industrial production have turned sharply worse, suggesting that even before Lehman’s fall, the economy, which has been sagging since last year, was falling off a cliff.

Tiny typo alert in the 11 July post on the EURO: Its other flaws from this this.

I don’t believe it’s the last chance — when GE has to borrow short term money by issuing new shares, it’s a clear sign of a huge problem, but it’s not yet the last step before disaster.

Why couldn’t they, or another company, ask 100 different small banks for small, $10 million short term loans? I bet they didn’t try — because they’re waiting for a BIG bailout, and the BIG solution. Banks waiting for a Big Solution from Big Government is becoming a significant contributing factor to the crisis.

Too many houses — house price values drop — too much financial paper on top of house values — too many bankers. So far the real crisis is 1) housing industry (few new residential units) (with evidence somewhere), and 2) financial houses, especially those with big MBS leveraged balance sheets.

But the near-recession we’ve been in does seem about to become a bigger slowdown, as the weakest (or slowest to use alternatives to Big Banks) firms can’t get short term money.

Funny, the arguments about weak companies unable to get short term money parallel the needs for weaker economies in the Eurozone (like Italy or Spain) to get short term money — so the Euro may indeed break up. Just as Slovakia is about to join in Jan.

Look at the TED spread. 3.6%+ over treasuries. This implies that each bank is basically stating “EVERY other bank has at 3% chance of imploding in the next 2 months AND NOT PAYING A DIME, DESPITE ANY GOVERNMENT BACKSTOP”. That is, assuming they will lend at all.

“It is now clear that the US financial system – and now even the system of financing of the corporate sector – is now in cardiac arrest and at a risk of a systemic financial meltdown. I don’t use these words lightly but at this point we have reached the final 12th step of my February paper on “The Risk of a Systemic Financial Meltdown: 12 Steps to a Financial Disaster” (Step 9 or the collapse of the major broker dealers has already widely occurred).”

Roubini is a professor of economics at NYU, noted expert in international finance, and founder of RGE Monitor (a aggregator of economics and finance articles, invaluable for anyone in those fields).

When GE, in order to get $3B in LONG TERM liquidity, has to pay 10%/year on it PLUS a 10% premium for complete payoff PLUS options with a strike price at current price for $3B worth of shares to Warren Buffet, you have a big problem.